Sunday, January 04, 2009

Taking Things for Granted

Many think we should cultivate the habit of thinking of what we are doing. The precise opposite is the case. Civilization advances by extending the number of important operations which we can perform without thinking about them.

~Alfred North Whitehead

I think 2008's problem was mainly because after the rating agencies were exposed as making an error on their AAA and AA ratings, all investors viewed such securities skeptically. What was previously an asset class that did not require much thought, now need re-underwriting: evaluating the credit from the bottom up. This is very difficult, invariably there are many assumptions (especially for derivatives), and you find very quickly that there are lots of unknowns that are potentially dangerous. Usually, these assumptions are benign, but as the mortgage crisis proved, you can't rest on 'usually'.

Looking at the AAA and AA ratings, which had had annual default rates of 0.01% and 0.03%, it is a wonder this did not happen earlier. With such low default rates, inevitably, mimics would exploit this because those buying such securities are not doing their own due diligence. You just have to find the right buzz words, and as Franklin Raines noted in his testimony on Capital Hill, "These assets are so riskless, that their capital should be under two percent". Anything backed by mortgages had such low historic loss rates, that it seemed silly to worry about things like income verification or a down payment. With hindsight, this was a huge error, but an error made by prominent academics, regulators, investment bankers, legislators, and investors. Once someone figured out how to game this assumption it was doomed, but that did not happen right away.

As Whitehead notes we make advances by putting complex tasks into processes that are automated, or applying generalizations so that we do not need to know particulars. When we have to stop and think about everything, our productivity shrinks drastically. It's a good thing for investors, especially large investors, to re-underwrite anything they have a large stake it. Unfortunately, changing regimes involves a lot of tumult, which is what constipated the savings-investment nexus.

Bernie Madoff's scam will also leave a big mark. Previously, a hedge fund could get away with merely showing returns, and be vague about how they were making money. Now, they need not only that, but a story. Where is the alpha coming from? Anyone doing due diligence needs to do the simple things, like seeing if a 'conversion strike strategy' is remotely plausible in generating promised returns. I think this will greatly slow the rebound in hedge funds, because some hedge funds think that when things recover, money will again flow into hedge funds, but the game has changed. A hedge fund now needs to articulate a story that is both plausible, yet does not reveal too much, because you don't want to tell people exactly what you are doing. I suspect many more systematic funds will have real problems here, pounding the table that their firm head is 'well-known' and trusted, and in combination with returns, implies investors do not 'need to know' details about the alpha generating process. As an investor, given Madoff, such trust would be foolish.